It is common these days to read and hear Europeans calling for a ‘new growth model.' This column argues that the end of complacency in Europe is a good thing, but this loss of confidence could be dangerous. It also discusses what needs to be done to make the European economic model different.

Related

Anaemic growth in Europe has raised questions not only on how to solve the current crisis (Dervis 2012, Levy 2012, Gros and Mayer 2012, Teulings 2012) or balance austerity and growth (Corsetti 2012), but even more fundamentally, it has shaken confidence in the euro and Europe. Ageing Europeans are being squeezed between innovative Americans and efficient Asians, it is said. With the debt crisis and demographics dragging down them down, one hears that European economies will not grow much unless radically new ways are discovered.

What Europe has achieved

The end of complacency in Europe is a good thing, but this loss of confidence could be dangerous. The danger is that in a rush to rejuvenate growth, the attractive attributes of the European development model could be abandoned along with the weak. Perhaps the most remarkable quality of the European economic model is its ability to take in poor countries and make them richer, what our report calls the European ‘convergence machine’ (Gill et al. 2012)1. Contrary to the rest of the world where capital flows from high to low growth economies (call it the China syndrome), in Europe countries receiving more capital flows grow faster.

The European growth model must also get credit for two other achievements. One is the building of a global brand. ‘European’ is shorthand for a combination of engineering and design that makes the continents goods and services desired around the world. This is an achievement of Europe’s enterprises, which have quietly thrived during the last two decades, matching those in America and Asia in generating increases in productivity, employment, and exports. The other achievement is that in spite of average incomes that are almost a quarter short of those in North America, Europe has become the world’s ‘lifestyle superpower’.

Figure 1. Economic convergence in Europe, not much elsewhere – Growth of consumption per capita between 1970 and 2009, by initial levels of consumption per capita in 1970

Source: World Bank staff.

How can Europe keep its convergence machine running? How can Europe’s brand be burnished? And what is needed to keep the European way of life?

What to keep, how to change

The short answer is that most countries in Europe are doing well in trade and finance, many are doing well in enterprise and innovation, but far fewer are doing well in work and government. So a lot of changes are needed in governments and labour markets, fewer to foster innovation, productivity growth and job creation by enterprises, and fewer still to reform finance and trade.

Trade. Trade is the mainstay of the European economic model, and its most attractive attribute. With trade ratios close to 100% of GDP, European economies are the most open in the world. Thanks to FDI and offshoring, enterprises in western Europe such as Volkswagen have made central and eastern European enterprises like Skoda more efficient and sophisticated (Marin 2010). Simpler tasks are being shipped off to countries outside Europe; advanced Europe is getting emerging Europe to do more difficult things, and both are benefiting.

The trade in modern – especially digital – services in Europe is increasing, but not fast enough for most Europeans. Trade in services requires a lot and the progress is mixed: travel has done well but transportation has not, and financial services have done well but not the other business services. With newer technologies and better regulations, Europe’s trade in services could triple in size over the next decade.

Finance. Financial integration is another strong point. Europe is the only part of the world where larger current account deficits – financed by capital inflows – have been associated with higher growth rates. The laws of economics have held in Europe. And they hold more firmly the more institutionally integrated the economies have become with western Europe – by membership in the EU, or by signaling the intention to join.

Figure 2. Capital inflows have helped poorer countries grow faster in Europe, not elsewhere – Current account deficits and per capita growth, by groups of countries

Note: Average growth rates calculated using three 4-year periods in 1997–2008.

Source: World Bank staff calculations based on IMF World Economic Outlook.

Of course, during the last boom some governments, enterprises, banks, and households abused the opportunities provided by this model of financial integration, but the benefits have been greater than the excesses. And the pullout of western banks from Europe’s emerging economies has been far less than many had feared although the risks of financial disintermediation in Europe are not banished. The lessons – better management of public finance during booms (in both advanced and emerging Europe), and strengthened regulatory structures to crisis-proof cross-border private finance. With these improvements, finance will be an even more enviable feature of the European economic model.

Enterprise. Europe expects a lot from its enterprises: more jobs, higher value added, and greater export earnings. Remarkably, during the last 15 years, European enterprises have delivered all three. Looking more closely at what has been happening recently, a sharper picture emerges. Northern countries such as Sweden and Ireland – and later the Baltic economies – do the best. Continental economies such as Germany and the Netherlands – and later Poland, Czech Republic, and others – do well too. Southern Europe – Greece, Italy, Portugal, and Spain – do not do well at all. Between 2002 and 2008, they created jobs, but in activities that were ephemeral (like construction) or in enterprises that are less productive (like micro and family firms). The chief culprit – high taxes and burdensome regulations, often poorly administered.

Figure 3. Much of Europe has become more productive, but the south has being falling behind – Labour productivity growth between 2002 and 2008, annual percentage increase

Note: The period of time considered is different for: Belgium and Norway (2003–08), Greece (2003–07), and France, United Kingdom, Czech Republic, Latvia, and Romania (2002–07). The three lines show average values for countries covered by each line. Expected growth for EU15 South is obtained by computing distances in productivity levels between EU15 South and each of the other two groups and then applying these shares to the difference in growth between the first (i.e., EFTA, EU15 North and EU15 Continental) and the third (EU12) groups. Source: World Bank staff calculations based on Eurostat Structural business statistics.

Europe will get even more from its enterprises if it made doing business easier. Countries such as Denmark, Ireland, Sweden, and the UK show that it can be done in Europe. Southern Europe has to do this now, central and eastern Europe will have to do it soon. Otherwise, enterprises will remain small and unproductive; unable to attract foreign investors and incapable of taking advantage of a pan-European market that will only get bigger, and increasingly uncompetitive in global markets compared with enterprises in east Asia and North America.

Innovation. During the last decade, two things have happened that should worry Europe’s entrepreneurs and policymakers. The first is that since the mid-1990s, labour productivity in Europe’s leading economies has been falling relative to the US and Japan. The second is that productivity in southern Europe has been falling compared both to the advanced countries in western Europe and the less well-off countries in emerging Europe. How can these innovation gaps be closed?

It depends on the gap. European economies such as Switzerland, Sweden, Finland, Denmark and Germany have been catching up to the US by essentially – to borrow Niall Ferguson’s phrase – ‘downloading the killer apps’ that have made the US an innovation machine (better incentives for enterprise-based private R&D, intellectual property regimes to foster profitable links between universities and firms etc.). For Europe’s larger continental economies that have reached or exceeded US standards in physical, financial, and even human capital, R&D and other innovation deficits are likely to be growth inhibitors.

In the dynamic east there is considerable scope for the quick adoption of existing technologies, using FDI and trade linkages as conduits. The south FDI flows have been dropping ever since the economies in emerging Europe have integrated with continental and northern Europe. For these increasingly service-oriented economies, reform of domestic regulations – not more R&D spending – may be the best way to speed up innovation.

Figure 4. Southern and eastern Europe must make it easier to do business: Principal component index of the ease of doing business in 2011, scaled from 0 (poor) to 100 (excellent)

Note: Averages computed using principal component analysis. The European Free Trade Association (EFTA) includes Iceland, Norway and Switzerland. The EU15 includes Denmark, Finland, Ireland, Sweden and the United Kingdom (north), Austria, Belgium, France, Germany, Luxembourg and the Netherlands (continental), and Greece, Italy, Portugal and Spain (south). The EU12 includes Estonia, Latvia and Lithuania (north), Czech Republic, Hungary, Poland, Slovak Republic and Slovenia (continental), and Bulgaria, Cyprus and Romania (south).Source: World Bank staff calculations based on Doing Business 2012.

Labour. The 45 countries covered by the report will lose about 50 million workers between now and 2060. Today, the European labour force is about 325 million people; in 50 years, with current levels of immigration and work participation trends it will be down to 275 million.

Only with radical changes can Europe counteract the shrinking of its labour force. Raising participation rates to levels seen in northern Europe cannot counteract the loss of young workers, because of continuously decreasing younger age cohorts2. Europe will have to work on many fronts to deal with coming labour shortages: improving labour mobility within Europe, delinking employment and social security, and rethinking immigration policies.

Perhaps the best way to start is to accelerate internal labour mobility in the EU. There will have to be changes in how wages are set, how housing markets are formalised, and how national safety nets are stitched together to cushion the shocks that come with mobility and migration. But the main attribute of the European economic model that needs to be reassessed is employment protection legislation, which is lowering participation and reducing employment in many countries in Europe. While this is being done, Europe’s policymakers could get people to appreciate the need for a new approach to immigration. Europe needs an immigration policy that is more selfish – driven by economic need instead of purely humanitarian concerns – and which helps makes the continent a global magnet for talent.

Government. Fiscal consolidation is a top policy priority in Europe. Fiscal pressures are high for five reasons: fiscal deficits and public debt increased sharply during the crisis; post-crisis growth might be weaker; rapid aging is adding to fiscal pressures; fiscal policy has to be put on a stable footing before the next crisis; and markets are paying more attention to fiscal vulnerabilities. Simulations suggest that Western Europe has to improve its primary balance – adjusted for the business cycle – by about 6% of GDP within this decade to reduce public debt to 60% of GDP by 2030. Adjustment needs are highest in the south and lowest in the north.

Figure 5. Europe’s pension systems have to support people for many more years: Changes in life expectancy at 60 and effective retirement age between 1965 and 2007

Source: OECD Health Data.

Figure 6. Social protection explains the difference in government size between Europe and its peers: Government spending, share of GDP, 2007-2008

Note: ‘Social protection’ includes benefits related to sickness and disability, old age, survivors, family and children, unemployment and housing.

Source: IMF Government Finance Statistics.

These adjustments are large but there is room for spending cuts that will not hurt growth. In fact, over the last 15 years, higher initial government size has led to lower growth. In Europe, a ten percentage point increase in initial government size leads to a reduction in annual growth by 0.6 to 0.9 percentage points. Government spending appears to especially reduce growth when its size exceeds 40% of GDP.

European governments on average are around ten percentage points of GDP bigger than their peers and this is in large measure explained by social spending. While public spending on health and education is not excessive, Europe spends more than peer countries on public pensions. In general, this is due not to an older population nor to higher pension benefits, but to easier eligibility for pensions – in some countries, the effective age of retirement has fallen by about ten years since the 1960s, even as people are living longer lives. European societies will have to reform social welfare systems so that disincentives to work are minimised. Countries spending more of 10% of GDP on social security may be taking resources away from investments in future growth.

In Europe, no middle income trap

Research at the World Bank identified 27 countries that have grown from middle-income to high-income since 1987. Some, such as Oman and Trinidad and Tobago, had discovered oil. Some, such as Japan, Hong Kong, Singapore, and South Korea, had translated peace into prosperity through aggressive export-led strategies which involved working and saving a lot and sometimes postponing political liberties for later. But of the countries that have grown from middle income to high income, half – Croatia, Cyprus, Czech Republic, Estonia, Greece, Hungary, Latvia, Malta, Poland, Portugal, Slovakia, and Slovenia – are in Europe.

If you can be a part of the formidable European convergence machine, you do not need to be extraordinarily fortunate to become prosperous, nor – like the Asian tigers – do you have to be ferocious. Countries in Europe just have to be disciplined.

2 First, if participation rates in all countries were to converge to those seen in northern Europe, or, second, if the retirement age were to increase by ten years across the board, the European labour force would actually increase marginally. If female labour force participation were to converge to that of men, the labour force would still decrease, but only by 5%, as opposed to 15% in the baseline scenario.